Price Forecasting with Harmonic Patterns

[RichardCox 10]

Harmonic patterns build on simple geometric chart patterns with the use of the Fibonacci sequence and the retracement and projection percentages that are typically associated with these numbers. Technical traders that use these patterns are looking for potential turning points after extreme trending moves are seen. But harmonic patterns are somewhat unique in that this trading approach looks to predict price movements, rather than to simply describe them.

 

For this reasons, harmonic patterns show some differences when compared to trend trading or the identification of overbought and oversold conditions. Many common trading methods involve simple reactions to market conditions, rather than actually attempting to predict (and project) what will happen next for the price of an asset. Here, we will look at some of the ways harmonic patterns are actively used in forex markets, and learn about some of the ways the “Divine Ratio” is actually put to use.

 

Looking for Repeating Price Patterns

 

Harmonic trading looks for patterns in price activity and positions are initiated based on the idea that certain types of patterns repeat themselves over time. The foundations of these patterns come from the 0.618 (or 1.618) ratio and its complementary Fibonacci ratios, which can be found in common retracement and projection analysis. The logic behind these applied ratios comes from the idea that the 0.618 ratio is common throughout nature and the universe and can even be found in structures that were made by human beings (unintentionally).

 

The prevalence of this ratio suggests that these measurements will apply to the financial markets as well, as these markets are a small part of a universal whole. In identifying price patterns of differing lengths and magnitudes, traders can use Fibonacci ratios to plot potential turning points. It is in these areas that actual trades are taken. The “Father” of the harmonic trading approach is considered to be H.M. Gartley but his foundational work did not actually use Fibonacci ratios in his analysis. In later years, Scott Carney has done major work to develop this form of analysis and many of the price patterns currently used are attributed to Carney.

 

Difficulties When Trading with Harmonics

 

The textbook structures for harmonic patterns are very precise, and require prices to unfold in movements of a set magnitude in order to signal a reversal point and trigger an actual trade. There will be many instances where traders might see a pattern that resembles one of the harmonic structures but if the Fibonacci measurements do not align with the predetermined requirements for the pattern, the structure is not valid. This essentially means that the shape itself is not enough (as it might be with a head and shoulders or flag pattern), to actually generate a trading signal. At the same time, however, this can be viewed as a positive as it takes out an element of subjectivity and can enhance the validity (and eventual accuracy) of the trading signals that are sent.

 

Structures Within Structures

 

One of the accepted strengths of harmonic patterns is that they give traders an indication of how long impulsive waves will last, in addition to the price points where the moves will occur. But the major trading difficulties are seen when the reversal area fails to catch prices and they continue in their original direction. This possibility always exists, and this is dangerous because harmonic patterns pick up extreme moves where price gaps can easily be seen. In this way, it can be more difficult to control risk when dealing with these patterns (despite the limited stop losses that are typically used).

 

Another factor to consider is that patterns can (and often will) exist inside other patterns. Multiple (smaller) price waves can be seen within a single (larger price wave), and this can go far to complicate and confuse the analysis. This can occur because of the fractal nature of harmonic analysis. Larger time frames tend to be viewed as being more reliable but it is preferable to see all of the available signals move in agreement.

 

It is also possible to see non-harmonic patterns inside the harmonic area and these patterns might show conflicting signals. But in cases where these patterns do agree (such as a reverse head and shoulders, and a bullish Crab pattern), this can offer an added level of validity to the signal.

 

The 4 Main Pattern Structures

 

At this stage, there are many harmonic patterns that can be traded but, generally speaking, there are four structures are are most common. The most well-known patterns are the Gartley, the Bat, the Crab, and the Butterfly. The first of these was the Gartley, originally introduced on the book Profits in the Stock Market. This original pattern dealt with simple fractions, rather than Fibonacci levels but it was on this pattern that all the later patterns were modeled.

 

As we can see in the first attachment, Fibonacci ratios were later added to the Gartley pattern. In bullish cases, the pattern tends to be seen at the beginning of an uptrend, with the downside corrective moves reaching completion at point D. This D Point is the 0.786 correction of the XA price move, and is the 1.27 (or 1.618) Fibonacci extension of the BC price move. This D Point is also referred to as the PRZ, or potential reversal zone. Buy positions can be established in this area, with stop losses slightly below the D Point. Bearish examples would be the mirror image of this scenario.

 

The Butterfly Pattern

The butterfly pattern is a variation from the Gartley in that it looks for reversals at new lows for bullish patterns and new highs for bearish patterns. Similarities are seen, however, at the D Point, which is still the reversal point. Fibonacci measurements of the D Point must show extension of BC equal to 1.618 or 2.618. This will be seen with the extension of XA equal to 1.27 or 1.618. The D Point is again the entry point, with stops taken just below this area (the PRZ) for bullish trades. The opposite would be true for bearish trades.

 

The Bat Pattern

 

The bat pattern is close in resemblance to the Gartley, but uses different Fibonacci measurements. The B Point in the Bat uses a smaller retracement of the move XA, equal to either 0.382 or 0.50 (not 0.618). The Fibonacci extension of the move from BC to D must be at least 1.618 but can extend as far as 2.618. This places the D Point at a 0.886 retracement of the initial XA price move. This area is the PRZ, where positions are established.

 

The Crab Pattern

Of all the harmonic patterns, the Crab pattern is the pattern that posts the best back testing results and is thought to be most accurate in price forecasting. The PRZ for these patterns is also the smallest of the group, which means that loss potential is more limited. Similar to the Butterfly, the Crab pattern identifies reversal point at a new low (bullish turns) or at a new high (bearish turns). For example, with a bullish Crab, we will see the B Point retrace a maximum of 0.618 of the move XA. The Fibonacci extension of the price move BC to the D Point is the largest of the group, as this ranges between 2.24 and 3.618. The PRZ at the D Point is an extension of 1.618 of the price move XA. Entries made at the D Point have the smallest PRZ, and the smallest stop loss levels. In the next part of this article, we will look at ways to fine-tune these trades and discuss a newly discovered harmonic pattern many traders might not have seen previously.